THE COLLAPSE OF CONTINENTAL ILLINOIS

Introduction

On May 9, 1984, Continental Illinois,1 Chicagos largest bank and one of the top ten banks in
the US, began a frantic battle to counter reports that it was on the brink of insolvency from a
combination of bad loans and funding liquidity risk.

At the root of the crisis lay a massive portfolio of energy sector loans that had begun to turn
sour on Continental when the US oil and gas sectors lurched into recession in 1981. The $33-
billion asset bank had compounded its mistakes by lending large amounts to lesser-developed
countries prior to the August 1982 start of the major LDC crisis of the 1980s.

With investors and creditors spooked by rumours that the bank might fail or be taken over,
Continental was quickly shut out of its usual domestic and international wholesale funding
markets.

By May 17, regulatory agencies and the banking industry had arranged billions of dollars in
emergency funding for the stricken giant. And in a move that remains controversial almost 20
years later, the Federal Deposit Insurance Corporation tried to stem the bleeding away of the
banks funds by extending a guarantee to uninsured depositors and creditors at the bank giving
credibility to the notion that some banks should be considered too big to fail.

The emergency help was followed by a package of permanent measures, making Continental
the largest bank in the history of US banking ever to be rescued by government agencies.2
The FDICs share of the bill was later calculated to be $1.1 billion.3

The Continental story provides a classic and timely4 example of how a sharp drop in
confidence can lead counterparties in the wholesale markets to suddenly withdraw funding
from a damaged bank, spinning the institution into a funding liquidity crisis as potentially
fatal as any nineteenth-century run on a bank by retail depositors.

Lessons learned

Its tempting for management to grow an institution by offering loans to the same credit-
hungry industry sectors. That incentive should be balanced by ensuring that portfolio
concentration risks are correctly measured and factored into lending decisions.
Decentralized lending decisions require controls and risk monitoring at the centre of the bank.
Deteriorating credit portfolios, leading to market rumour and the withdrawal of competitively
priced funding, can send even large institutions careening down the liquidity death spiral.
Some banks might be too big to fail from depositors and regulators point of view. But
shareholders will still lose their shirts.

The story
In the mid 1970s, Continental Illinois embarked on a strategy of growth that over the next
half-decade would make the bank the largest commercial and industrial lender in the US. As a
result, according to a later FDIC report on the Continental Illinois debacle,5 the banks
lending to commercial and industrial clients grew from $5 billion to $14 billion between 1976
and 1981.

Throughout this extended honeymoon period, the growth strategy seemed to give good
results. In the late 1970s, Continental achieved an above-average return on equity putting it at
the top of the commercial banking league and was showered with praise by equity analysts. In
turn, its share price moved upwards, doubling in the five years to 1979 and continuing to rise
to a peak in June 1981 (an exceptional performance).

But Continentals focus on commercial clients many of its peers diversified their lines of
business to include large retail businesses meant that it needed to be a master of commercial
credit risk management in terms of loan underwriting and portfolio risk management.

Commercial banking, after all, is notoriously dependent on national and regional economic
cycles. A commercial banks interest rate margin the positive gap between the rate a bank pays
depositors for funds and the interest rate it is able to charge borrowers can be quickly eaten up
by any jump in customer default rates when recession bites.

One result of this is that fast-growing commercial banks are often in danger of buying market
share by lending at rates that will not offset the default risk of their loans over the entire
economic cycle. (Early-cycle default rates are reassuringly but deceptively low; they can
change significantly as macro-economic conditions change.)

This is a particular danger when banks concentrate lending in a particular industry sector, the
banking equivalent of putting all your eggs in one basket. Through the late 1970s, Continental
worked hard to build up its energy industry business, a sector in which it felt it had special
expertise.

One of the tools that Continental employed to speed up this expansion in energy assets was its
relationship with Oklahoma-based Penn Square Bank, a $436-million asset bank that
specialised in oil and gas sector loans. While Penn Square originated large volumes of loans
to the historically risky exploration sector of the US energy industry, Continental participated
bought a share in the smaller banks lending book, ultimately to the tune of hundreds of
millions of dollars.

Continental also expanded its assets in another credit-hungry sector by lending to lesser-
developed countries in Latin America such as Mexico. Many large commercial US banks
followed the same strategy in the late 1970s. But Continentals credit exposures were
compounded by its unusual funding strategy.

Traditionally, banks fund growth in their lending activities by attracting larger volumes of
savings from retail depositors. Continental, however, had only a limited retail presence, due in
part to federal and local banking regulations that restricted its ability to build a branch
network.

This meant that the bank came to depend increasingly on funding from the wholesale money
markets. Indeed, by 1981, Continental gained most of its funding through federal funds and
by selling short-term certificates of deposit on the wholesale money markets, sourcing only
20% of its funding from traditional retail deposits.

The banks funding strategy meant that Continental was vulnerable to the wholesale funding
markets interpretation of its concentrated exposure to the energy and LDC credit sectors. That
worked well during the 1970s, but both sectors faced extraordinary challenges as the 1980s
dawned.

After years of oil price rises and industry expansion, oil prices began to drop in April 1981.
They continued to decline for a number of years, along with the fortunes of energy-sector
companies. Exploration and drilling companies were inevitably among the first to bear the full
brunt of the downturn. Continentals share price began a steep decline, losing over half of its
value from mid 1981 to mid 1982.

Through the first half of 1982, most analysts continued to think that any deterioration in
Continentals credit portfolio would threaten the banks profitability, not its solvency. After all,
Continental was a long-established and substantial bank, with a good earnings record and a
triple-A agency rating for its debt.

But two events in the summer of 1982 swung opinion against Continental. The most
immediately important was the collapse of Penn Square Bank in July 1982 under the weight
of poorly underwritten loans to the ailing energy sector. The collapse revealed the extent of
Continentals participation in Penn Squares lending and underlined the damage that was being
wrought on banks that had specialised in energy-linked lending. Continental was forced to
report $1.3 billion in non-performing assets in the second quarter of 1982.

The Penn Square collapse was closely followed by Mexicos August 1982 debt default, which
triggered the 1980s LDC crisis. All of a sudden, Continentals credit portfolio looked like a
high-risk gamble.

With market participants becoming worried about Continentals long-term solvency, the bank
began to feel the liquidity squeeze inherent in its funding strategy. It found itself paying
higher rates on its certificates of deposit as it fell out of favour with savvy domestic
counterparties in the wholesale money markets. Increasingly, the bank turned to the foreign
Eurodollar money markets for funding, which it could secure by paying relatively high rates.
This, however, depressed the banks profit margin and left it vulnerable to any further panic
about its creditworthiness in the international markets.

The bank struggled through 1983, its financial health boosted by the one-off sale of a
profitable credit card business. But though there were occasional rallies in Continentals share
price, these proved short lived. And while the bank agreed a plan with the OCC to improve its
asset/liability management, loan administration and funding, 6 little could be done to prevent
chronic deterioration in the health of the loan portfolio it had built up in the period before the
Penn Square collapse. Wrong-footed by rising interest rates and increasing LDC debt
problems, Continental announced another increase in non-performing loans, to $2.3 billion, at
the end of the first quarter of 1984.

Rumours circulated widely about the banks financial condition during the spring of that year.
International banks began to charge Continental higher rates for funds, a widening of the
banks credit spread that may itself have triggered further rumours when it became the subject
of a news wire story on May 8. 7 On May 9, rumours of Continentals credit problems, and of
a possible take-over, reached a crescendo as a run on the banks funding instruments
developed in Tokyo and on other international money markets.

The flight of billions of dollars of short-term funding from Continental in the days following
May 9 was rather like a classic nineteenth-century run on a bank by depositors. The difference
was that instead of queues of angry customers forming outside the bank, the flight of capital
was conducted electronically by institutional investors in the Eurodollar money markets. Most
of these investors did not have to withdraw money; they simply refused to roll over the money
they had on deposit with the bank at short maturities.

With financial journalists questioning Continentals solvency, the Office of the Comptroller of
the Currency (OCC), its lead regulator, felt obliged to state publicly that it had no reason to
question the banks soundness.

The regulators reassurances were to little avail. On May 11 the bank was obliged to borrow
$3.6 billion from the Federal Reserves discount window to make good the outflow of funds.
Within days 16 banks had put together an additional $4.5 billion emergency package of loans
for the stricken bank but the run on the bank continued.

Meanwhile, the reliance of other US banks on Continental led to fears that a failure of the
bank would trigger a loss of confidence in US banks by foreign investors and lead to a
systemic crisis. In particular, some 2300 US banks held deposits in correspondence accounts
at Continental, leading to fears that an unknown number perhaps a hundred or so might be
catapulted into insolvency in the event of a crisis. (Studies after the event have tended to
downplay the likely number of fatalities, suggesting that only a handful of small banks were
at risk of failure.8 )

The Comptroller of the Currency at the time, Todd Conover, later summed up the regulators
dilemma at the moment of crisis:

We debated at some length how to handle the situation. In our collective judgment, had
Continental failed and been treated in a way in which depositors and creditors were not made
whole, we could very well have seen a national, if not international, financial crisis the
dimensions of which were difficult to imagine. None of us wanted to find out.9

On May 17, the FDIC, Federal Reserve and OCC announced how much they were willing to
pay to remain ignorant of whether Continental really was too big to fail. The package they
announced in a joint press statement included:

- An additional $2 billion in funding for the bank arranged by the FDIC and the banking
industry;
- Federal Reserve assurances about providing liquidity;
- Twenty-four major banks would provide $5.3 billion in unsecured funds until a more
permanent solution could be found; and, controversially,
- The FDIC said it would make good all of the banks depositors and creditors, setting aside
the $100,000 limit on deposit insurance that should have governed its payouts.

The FDIC extension of its guarantee to all uninsured depositors and creditors was highly
unusual. It was made because most of Continentals funding was in the form of uninsured
deposits and regulators believed that this would continue to drive the bank run unless such an
assurance was given.

The emergency measures provided a temporary breathing space in which regulators looked
for another institution that would agree to take over Continental. The worries about
Continentals impaired portfolio and legal entanglements were such that the search proved
fruitless.

In July, regulators hammered out a controversial approach to permanently rescuing the

institution under which the FDIC would purchase some $4.5 billion book value of impaired
loans with an adjusted book value of $3.5 billion in return for assuming $3.5 billion of the
banks Federal Reserve debt.

The so-called permanent assistance program was put into place on 26 September. But the
impaired loan portfolio, composed largely of energy and international shipping loans, was so
large and complex that the FDIC had to ask Continental itself to manage the loans through a
special unit (under strict FDIC oversight).

Under the permanent assistance program, the FDIC also acquired preferred stock in
Continentals holding company, in return for infusing $1 billion in equity capital into the bank.
This transaction effectively left the government agency as the 80% owner of the bank a
nationalisation in everything but name.10

The aftermath

The rescue package meant that, controversially, creditors who held the debt of the bank
holding company did not lose their money. It also gave fresh life to the widely held belief that
some banks were simply too big to fail that their demise would have such disastrous systemic
implications that regulators would never permit them to collapse.

But the label too big too fail is potentially misleading. Shareholders in the bank lost most of
the value of their investment immediately after the FDICs stock purchase. They lost the rest
of the value of their investment later on, when the FDIC exercised an option to purchase the
remaining shares. (The option became exercisable because the losses from the FDIC-assumed
impaired loan portfolio reached a pre-agreed level.)

Even so, the Continental rescue clearly suggested that uninsured depositors and creditors
would be bailed out using taxpayers money if regulators became scared enough about the
systemic effects of letting a large bank go to the wall. Shortly after the Continental episode,
regulators testifying to Congress admitted that the eleven largest banks in the US were indeed
regarded as too big to fail.

This implied government guarantee upset smaller banks in the US, who argued that the too
big to fail concept was, in effect, a government subsidy for larger banks. Following the
savings and loan sector debacle later in the 1980s, a series of reforms of US banking
regulation addressed some of the issues of the too big to fail debate, particularly in terms of
making sure that uninsured depositors bore a greater proportion of the cost of bank failure.11
But the question of how regulators will react when they are again faced with potential
systemic repercussions from the meltdown of a very large bank remains open. The answer is
more important than ever: since 1984 major US banks have vastly increased in size through
merger and acquisition.12

The rescue of Continental Illinois had many lessons for regulators, but these should not be
allowed to outshine the lessons the story contains for bank risk managers. Continentals
troubles remain an object lesson in how a disaster can begin with underwriting decisions,
snowball through the poor management of portfolio concentration risk, and culminate in a
violent explosion of market rumour and funding liquidity risk.

Timeline

1976 - 1981: Continental grows fast, lending to the energy sector and lesser-developed
countries

1981: Continental hits a high point in terms of asset size and by now employs some 12,000
people

1981: The US energy sector, hit by oil price falls, moves towards recession

July 1982: Energy-sector specialist Penn Square Bank fails, causing concern about
Continental, a major participant in Penn Squares risky lending programme

August 1982: Mexico defaults on debt, sparking LDC debt crisis

Spring 1984: With non-performing loans rising sharply, Continentals critics are now
wondering about its solvency

9 May: Final liquidity crisis begins in Eurodollar markets as rumours swirl about Continentals
creditworthiness

11 May: Continental forced to borrow $3.6 billion through Fed discount window

14 May: 16 banks put together rescue package of funding, but the run on Continental
continues

17 May: Unprecedented interim assistance package announced by panicked regulators.

Uninsured depositors and creditors given FDIC assurances.

July: With it proving difficult to find a purchaser for the bank, regulators work with
Continental to devise a permanent solution

26 September: Permanent solution put in place, effectively nationalising Continental using

FDIC funds

1991: FDIC sells off its last equity stake in Continental, bringing the rescue programme to a
close some seven years after the banks near collapse